China Bank Bears Must Brace for Disappointment

The government's efforts to stem nonperforming loans may already be paying dividends.

China is addressing bad debts.

Photographer: Teh Ehg Koon

Global investors concerned about a looming spike in Chinese nonperforming loans should take a look at recent data from the China Banking Regulatory Commission. If they did, then maybe they wouldn’t have as much angst. The CBRC said last week that the NPL ratio at the end of the second quarter was flat at 1.74 percent, while net interest margins improved to 2.05 percent, up from 2.03 percent in the first quarter. Those numbers suggest China’s banks will report stable first-half earnings.

While some will question whether the positive trend is sustainable, the reality is that it’s hard to fight the efforts of the government, which is accelerating changes to bolster the banking system. Over the past year, China has announced several policies to reduce NPL risks at the major banks, such as requiring credit committees, enabling local asset management companies, promoting debt-for-equity swaps, encouraging the growth in securitization, and promoting new state-owned enterprise capital management holding companies. Regional asset management companies are likely to play an increasingly important role in managing bad assets, possibly by stepping up purchases of NPLs. 

Finally, asset quality will also get a boost from the improvement in corporate earnings, which have been helped by China’s strong first-half economic growth, as well as progress in supply-side reforms. Industrial companies’ profit increased by 19.1 percent in the first six months of 2017 from the same period a year earlier, compared with single-digit growth in 2016 and a decline in 2015.

I can understand why investors are concerned about Chinese banks. The speed and magnitude of debt accumulation has been high by historical standards, and the primary source of rising leveraging is the corporate sector, where debt has increased from approximately 85 percent of gross domestic product in 2008 to more than 150 percent today. The International Monetary Fund estimates that China’s corporate and government debt will increase to almost 300 percent of GDP by 2022. In an interview with Bloomberg News, Markus Rodlauer, the IMF’s deputy director of the Asia-Pacific department, warned that “things haven’t ended well” in other countries when debt reaches those levels.

The credit allocation process at banks needs further reform, as lending has been increasingly channeled into non-productivity-enhancing segments, specifically the property market and industrial sectors with existing overcapacity. Also, SOEs have taken over a disproportionate percentage of bank credit for their size. This has left private enterprises either starved of capital or turning to more expensive shadow financing. Short-term wholesale funding has become increasingly popular among Chinese banks looking to finance off-balance-sheet investments, raising concerns about maturity mismatches, leverage and risk transmission between money markets and credit markets. The growth in wholesale funding has also increased interconnectedness of the Chinese banks, which increases the potential for systematic risk during times of elevated stress.

Those pushing the “China crash scenario” generally highlight the following factors: 1) continuing increases in debt levels and overinvestment; 2) policy adjustments that are fatally delayed; 3) ultimately, when short-term rates start to increase, this will cause a material pickup in NPLs and subsequent slowdown in economic growth.

While I am not sanguine about credit risks, China has the ability to control the speed of loan defaults as a significant portion of the lending in the system is by state-owned banks and companies. In addition, a large proportion of the financial burden of NPLs will be born mainly by provincial asset management companies rather than listed SOE banks. That said, more policy emphasis must be placed on de-risking and further regulation of shadow banking. 

The pace of structural reform must also be accelerated, particularly in the state sector. I agree with the IMF’s recent announcement that increasing government spending on health and pensions is needed to facilitate China’s growth transition toward consumption. Finally, it’s vital that the government acts quickly and comprehensively to slow the pace of debt accumulation. The potential adverse consequences of China’s credit boom to date are manageable, but if the current pace of debt accumulation does not slow and structural reform does not accelerate, China’s financial problems will increase materially. For China policy, time is of the essence.

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